The Index Bubble: Michael Burry Interview Explained

hey guys it’s down here and welcome back
to my channel in today’s video I’m going
to talk in a ways that anyone can
understand some recent criticisms that
were directed towards index funds by
Michael burry and his concerns that
index funds are a bubble now I’m also
going to talk about why I think his
concerns are misguided and explain why I
think index funds are still a solid
choice to grow your wealth and cheap
early financial independence
so Michael burry recently did an
interview with Bloomberg where he was
sharing his concerns that index funds
are causing a bubble if you don’t know
who Michael burry is he is well known in
the financial world for having predicted
the housing bubble back in 2018 and he
made a fortune betting on the housing
betting against the housing market you
may also know him as the guy who was
portrayed by Christian Bale in the
popular 2015 would be called the big
short if he has seen some other videos
you know I’m a big proponent of low-cost
passive simple index investing which is
probably by far the most popular
investment for the fire movement which
stands for financial independence retire
early so any criticism of index funds or
ETFs coming from somebody as
well-regarded and as brilliant as
Michael burry is something that I think
is worth considering in this interview
has main criticism I think can be summed
up in two points the first one is price
distortion and the second point is
liquidity risk so his first criticism
starts in this paragraph index fund
inflows are now distorting crisis for
stocks and bonds in much the same way
that CDO purchases did for subprime
mortgages more than a decade ago so how
exactly does he think index funds
distort these prices well he goes into
detail in a later paragraph he says
passive investing has removed price
discovery from the equity markets the
simple theses and the models that get
people into sectors factors indices or
ETFs and mutual funds and mimicking
those strategies these do not require
the security level analysis that is
required for true price discovery I am
posting a link to this interview down in
the description below so then you can
read it on your own time
you are interested and while you’re down
there be sure to drop a like to support
this video and my channel and as well as
if you haven’t subscribed already be
sure to subscribe so that you don’t miss
on any new videos to help you grow your
wealth and achieve financial
independence so let’s first talk about
what is price discovery as it relates to
the stock market so simply put price
discovery is the process in which you go
about to figure out what is the price or
value of a company so you may be
thinking well what does that exactly
look like well here’s how you can
picture it every morning thousands of
Wall Street professionals go to work to
analyze thousands of companies to figure
out what is the truth value of those
companies once these analysts and
traders are able to figure out what they
think a company is actually worth
they’ll go ahead and look at the stock
price and determine if it’s undervalued
or overvalued or fair value and then
they’ll decide whether to buy sell or
wait it out so this is what you would
call actively trading these experts are
actively trying to find it opportunities
and the price gaps in the stock market
to make money so what Barry is saying is
that the passive investing for example
like buying into the S&P 500 index fund
right means you’re not doing any price
discovery at all in a sense you’re just
buying the stocks of 500 companies in
the S&P 500 without any thought for what
their true prices are so there’s no
expert or an analyst behind the
index fund letting you know whether or
not you’re overpaying for the phone
company or under paying for the company
and just as a side note in regards to
his reference to CDOs or collateral debt
obligations and their connection to
subprime mortgages that is a very
different situation than index fund
investing and the stock market or the
bond market without getting sucked down
this rabbit trail CDOs can be extremely
complex investments whereas I think even
a fifth grader can understand in index
funds and how they work so the
connection that he’s trying to make I
think is a bit of a stretch and I feel
like his motive for even mentioning it
in the first place in this interview is
sensational than anything else really to
hark back to the emotions and the fears
and the in the chaos and the craziness
of the last financial crisis so going
back to what burry is saying so if you
follow his logic what basically is
saying is that the massive amount of
money that is in passive index funds in
ETs have gone so large and nobody’s
thinking about the prices that they’re
paying for these companies and by
blindly buying massive amounts of stock
of companies that are listed in whatever
index you’re basically inflating their
stock price beyond what they’re actually
worth and therefore index investing is
causing a bubble now burry is absolutely
right in that passive index funds and
ETFs have grown tremendously over the
last two decades we’re now at least in
the United States
passive funds make up close to half of
all assets under management CNBC had
published this article about passive
investing back in March and I suspect
now that it’s probably closer to 50% and
if you look at this chart down here it
shows just how much passively managed
funds have grown as a percentage of the
market from 2009 to 2018 but the truth
is and this is the key detail that I
think you need to realize that even
though passive index funds and ETFs make
up a bigger proportion of assets than
ever before they only make up a tiny
fraction of all trading activity and
trading is what determines price in fact
a Vanguard research paper from 2018
states that because index strategies
have low turnover and trade at the
margin across the large list of
securities their impact on trading
activity is minimal figure eight which
I’m popping up here shows that the
portfolio management activity of
indexing makes up about 5% of daily
trading volume on US exchanges the
research paper continues to say other
market participants including but not
limited to retail investors
high-frequency traders and pension funds
account for the vast majority of
training volume active participants play
the dominant role in security trading, thereby
facilitating price discovery so just because
the amount of money in passive index
funds and ETFs has grown so much does
not mean that prices are being distorted
by these funds because they don’t buy
and sell stock positions all that
frequently compared to actively managed
funds if you think about it and for this
we can take a S&P 500 index fund as an
example the only time it would need to
buy or sell is when a company is added
or dropped from the S&P 500 index and
periodically when changes in the market
value of the companies requires
adjustments in the market value
weightings this is also true of index ETFs
and if you’re not familiar with what
ETFs are and how they’re different from
index funds
I recommend watch this video up here
where I break down the differences and
similarities in a way that anyone can
understand basically ETF trading volume
is almost always the buying and selling
of ETF fund units not the funds actual
stock positions so in fact the Vanguard
research paper that I had just mentioned
they lay out the facts and the date on
this so I’ll link to that paper it down
in the description so you can go and
take a look at it if you’re interested
in more details so the bottom line is
this the argument that passive investing
is distorting stock prices doesn’t make
sense because passive funds trade so
little really the reality is that price
discoveries being done by active traders
is still alive and well and they’re not
gonna go away anytime soon if ever with
cheaper alternatives to the traditional
brokerage account like and M1 finance
or RobinHood active trading is more
accessible than ever before to just look
anyone with the phone and internet
connection all you have to do is do a
quick search on YouTube to find just
about everyone and their moms posting
videos on how their RobinHood account
is the best thing since sliced bread all
this goes to say that as long as some
people somewhere think that they can
beat the market active trading will
always exist alongside
passive investing and those active
traders will by their very nature keep
actual prices as close to the true
prices in most cases if you think about
it there can never be a situation where
passive investors make 100 percent of
the trades if that were true and all
stocks were bought and sold blindly by
passive investors and nobody was doing
price discovery the opportunities to
take advantage of the market would be so
abundant and easy that everyone would
just rush into active training to profit
off of the laziness and/or the
ignorance of passive investors so there
will always be a balance between passive
investors and active traders at all
times where that balance is is really
hard to say but I do like mr money
mustache is response to a question of
how many active investors does it take
to balance the market he writes if
actively managed funds start
consistently outperforming index funds
on average across the entire industry
then we have reached a point of peak
indexing and you should switch to a good
low fee active fund to summarize passive
investing does not distort stock prices
because most trading is done by active
investors who through their price
discovery keep the market in check
alright so moving with the liquidity
risk so in the article here is the
paragraph that details his criticism
which i think is a bit unnecessarily
convoluted so I’m not going to read it
here but basically what he is saying is
that because there’s so much money
invested into small and medium-sized
companies that don’t trade very often if
there’s a downturn in which there’s a
mad rush to sell the prices of these
companies will tank and therefore
everyone will lose a lot of money
I think this argument pretty weak
because long-term passive investors
don’t really sell I mean they are passive
for a reason these people buy index
funds and ETFs regardless of the
short-term price fluctuations and
frankly there’s a lot more interesting
and volatile assets out there to play
that game than boring index funds and
ETFs so if you were part of fire movement
don’t have any intention of selling due
to these big pricings so I think there
is a bit of a misconception on
Michael Burry’s part about the type of
people who buy into a passive index
funds and ETFs but you know maybe there
are people who who are buying into a
passive investing without thinking
through what they exactly signed up for
and so only time will tell if they have
the stomach to ride out those major
losses especially during a recession or
a really volatile market especially for
some of the younger folks who have never
experienced a full-blown recession or
double digit losses I think there’s a
lesson to be learned in what Michael
burry is saying in that succeeding as a
passive investor requires a great deal
of emotional self-control and financial
discipline and for some of us who have
only been investing since after the last
financial crisis I don’t think we’ve
truly been tested and how much we
believe in this passive investing
bandwagon if you enjoyed this video be
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financial independence thanks for
watching and I’ll see you guys next time


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